Debt fight poses new risk to U.S. credit rating

Wall Street rating agencies are starting to sound warnings again about the possibility of further downgrades of the once-perfect U.S. credit rating as a critical year-end deadline for addressing the nation’s mounting debt nears.

Standard & Poor’s Corp. this week said that the outlook for the U.S. rating is negative and suggested that it will downgrade the U.S. again if the political impasse over tax and entitlement reform extends into next year. The agency shook world markets last summer by downgrading the U.S. for the first time to AA+ from AAA.

S&P cites extreme politics as the biggest problem, and one that is getting worse as the presidential race and fight for control of Congress heats up. The agency doesn’t expect the political environment to improve after the elections - no matter who wins. At that point, Congress will have only two months to avert a massive fiscal train wreck from hitting the economy with huge tax increases and spending cuts at year’s end.

“Political polarization has increased,” with serious consequences for the nation’s ability to manage its growing debts, said S&P analyst Nikola G. Swann. He noted that neither party has been able to muster broad bipartisan support for any major measure to address the deficit and prevent the debt from eventually getting out of control.

The agency noted that President Obama and both parties in Congress spurned the recommendations of a bipartisan presidential commission whose December 2010 plan could have brought the deficit and debt down to manageable levels. Further, another bipartisan panel appointed by the leaders of both parties last fall failed to draft an alternative plan and broke up amid partisan finger-pointing.

Political impasse

This year, with hyperpolitical posturing on all sides, Washington has abandoned all attempts at bipartisan agreement, despite the looming deadline.

The move toward extremes by both parties - with Democrats refusing to consider major reforms in fast-growing entitlement programs such as Social Security and Medicare, and Republicans refusing to consider raising taxes or even closing tax loopholes to reduce the deficit - has made finding a middle ground increasingly difficult, S&P said.

As this impasse deepens, it raises questions about the government’s willingness to sustain its unprecedented $11 trillion mountain of public debt, S&P said, while Congress’ commitment to avoiding default is increasingly being tested by politicking over legislative measures needed to increase the official debt limit.

When the fiscal deadline arrives Jan. 1, S&P said, it expects an estimated $500 billion in George W. Bush-era tax cuts to be extended again, as one of the few points of agreement between the parties is that they must prevent a sudden fiscal contraction that would be devastating for the still-recovering U.S. economy, even though it would drive up deficits in the near term.

But S&P doesn’t expect the two parties to go beyond that and agree on major spending and tax reforms needed to control the debt.

What will be left in place is an already approved $1.2 trillion of cuts in defense and domestic discretionary spending, enacted as part of a debt-limit deal last summer, which S&P expects will serve to keep a lid on the deficit, cutting it in half to 5 percent of economic output by 2016 - still a high and unsustainable level in its view.

Should this reading of the political tea leaves prove accurate, the agency said, it likely would downgrade the U.S. again next year. The Wall Street agency stressed that most of the risks for U.S. debt holders are political, as the fundamental economic and credit strength of the U.S. remains strong and it enjoys the benefits of the dollar’s reserve-currency status and a well-managed Federal Reserve.

Moody’s doubt

Moody’s Investors Service, Wall Street’s second most powerful rating agency, which so far has not downgraded the U.S. from AAA, also recently voiced misgivings about the burgeoning growth of U.S. debt and liabilities, and said the negative outlook for America’s top rating has darkened.

Moody’s says it will evaluate the U.S. rating in light of what happens in the elections and months afterward. But it was troubled by a Social Security trustees report this spring showing that projected outlays for the retirement program will nearly double to $927 billion in the next decade because of earlier-than-expected baby boomer retirements and growing disability claims.

The unexpected surge in spending, which many economists attribute to layoffs during the recession that pushed many baby boomers to apply for early retirement and disability benefits, means the program from this point on will spend more than it takes in in payroll taxes, and will fall into insolvency three years earlier, in 2033, Moody’s noted.

“The projected cost increase is credit negative for the federal government,” said Moody’s Vice President Steven Hess. Moody’s has indicated that it might downgrade the U.S. if Congress and the president do not enact a major deficit-reduction deal addressing the need for entitlement reforms after the elections.

Any downgrade by Moody’s could be more devastating than a second downgrade by S&P, analysts say, because it would clearly move the U.S. out of the exclusive club of AAA-rated nations and throw into question the privileged status of U.S. Treasury securities as a safe haven for global investors.

Threat to Treasury

Any significant flight from the Treasury market triggered by a downgrade would raise Treasury bond rates and have devastating consequences. The Congressional Budget Office has estimated that a 1-percentage-point increase in rates would increase Treasury’s debt payments by $1 trillion in the next decade, wiping out the benefit of all the budget cuts enacted by Congress last year.

Treasury’s safe-haven status is the critical factor that enabled the U.S. to avoid a debilitating increase in interest rates after the S&P downgrade last year, said Ivan Rudolph-Shabinsky, an analyst at AllianceBernstein.

In fact, Treasury rates declined after the S&P downgrade as the U.S. benefited from the turmoil created by the European debt crisis. The flight to safety by investors drawing out of Europe has pushed Treasury rates to record lows, with the yield on Treasury’s 10-year bond falling for the first time to 1.44 percent.

Those extraordinarily low interest rates not only have enabled the U.S. government to easily finance its growing debt load, but have been a boon to the beleaguered U.S. housing market and indebted U.S. consumers.

Thirty-year mortgage rates, which are linked to the 10-year bond rate, have plunged to record lows, below 4 percent, triggering a big wave of refinancings and boosting prospects for a budding housing recovery.

Mr. Rudolph-Shabinsky said America’s safe-haven status doesn’t appear to be in much danger, but how markets view the political impasse will be critical.

“The current assumption is that the threat of a potential crisis will spur the U.S. government to act” to reduce the debt at the end of the year, he said. But what if global investors conclude, like S&P, that “the U.S. is simply incapable of addressing its underlying structural issues with Social Security, Medicare and other entitlement programs?”

In that case, Treasury yields will rise and “higher financing costs will cause a dramatic deterioration” in U.S. finances, he said, possibly putting the U.S. in the same boat with Greece, Spain and other debt-strapped European countries.

“The U.S. might fall into the category of sovereign downgrades that accelerate an already-worsening fiscal situation,” he said.